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Income Builder Model Portfolio

Monthly Portfolio Review: June 2024

Publication date: July 2, 2024

Current portfolio holdings

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Executive summary

• The Income Builder portfolio delivered a 0.9% total return in June.

• The S&P 500 returned 3.6%, with the vast majority of the positive performance of the index generated by “Magnificent Seven” tech stocks.

• While most of the upside in the broader market can be attributed to tech sector beneficiaries of the AI theme, the Income Builder did benefit through data center REIT Digital Realty Trust (DLR), which advanced 5%, and natural gas pipeline operator Williams (WMB), which advanced 4%.

• The top performer in the portfolio was Mid-America Apartment Communities (MAA), up 7%. MAA has a number of factors now working in its favor.

• Alternative asset manager Carlyle Group (CG) was the worst performer in the portfolio and declined 7%.

Performance review

During the month of June, the Income Builder portfolio generated a 0.9% total return. This compares to a total return of the S&P 500 Index of approximately 3.6%. Individual position returns across the portfolio ranged from -7% for Carlyle Group (CG) to 7% for Mid-America Apartment Communities (MAA).

We generally use the S&P 500 Index as a reference point for interpreting month to month performance. It is the most prominent U.S. stock market index and is very widely owned through passive funds. But a month like June 2024 highlights a number of important considerations associated with using the S&P 500 as a performance benchmark, especially over short time frames.

The S&P 500 Index is market capitalization weighted, like most major market indices (with the price weighted Dow Jones Industrial Average being a very antiquated exception). This means that the more valuable a company is, the higher its weight within the index.

The theory behind market capitalization weighted indices is that they reflect the allocation of all investors to the relevant investment universe. The point is to mimic the positioning of the average investor.

Winner-take-all

Over time, the S&P 500 Index has become increasingly concentrated in a handful of “mega cap” stocks, the vast majority of which are technology stocks or at least technology-related. There are many potential explanations for this, but one that we find quite compelling is the thesis laid out over 25 years ago in a well-received business book called The Gorilla Game by Geoffrey A. Moore.  

Moore describes what he calls the “tornado theory.” A “tornado” is a “compressed period of hypergrowth” that “creates a unique set of marketplace dynamics that frequently will catapult a single company into a position of overwhelmingly dominant competitive advantage,” which then allows the company to “generate exceptional returns to its investors for an unusually extended period.”

Over the past several decades, a handful of technology-related stocks have become immensely valuable (arguably because of this “winner-take-all” tendency within the technology space). These stocks now have disproportionate representation within the S&P 500 Index and often dominate its returns.

Investors have given various names to these market bellwethers. “FAANGs” was popular for a while, but then Facebook changed its name to Meta, Google officially became Alphabet and Netflix subsided in importance. Today, “Magnificent Seven” is most commonly used.

“Mag Seven” representation in S&P 500 ETF (SPY) (Source: FactSet)

The Magnificent Seven at the moment do not perfectly match the market cap leaders of the S&P 500, as Tesla has slipped down the list. But Mag Seven is still a useful shorthand for understanding market concentration.

In June 2024, the Mag Seven performed exceptionally well and delivered the vast majority of the 3.6% total return of the index. We estimate the contribution was approximately 3%.

Conveniently, an ETF has been created, called the Roundhill Magnificent Seven ETF (MAGS), that tracks the Mag Seven on an equal-weighted basis. We can see the profound impact that Mag Seven stocks had on the S&P 500 Index in June by comparing the performance of this ETF versus the index.

The importance of the Mag Seven, and the largest market capitalization stocks in general, to the June performance outcome is also visible in the relative performance of the S&P 500 versus the S&P 500 Equal Weighted Index. Rather than assigning a weighting based on relative market cap, the Equal Weighted Index simply gives all stocks within the index the same allocation.

On an equal weighted basis, the S&P 500 declined in June by approximately 0.5% and lagged the market-cap weighted return by approximately 4%.

To some extent, the outperformance of large market cap stocks simply reflects the outperformance of the technology sector, even though most of the Mag Seven names are not technically classified as “Information Technology” under the Global Industry Classification Standard used by S&P.

AMZN and TSLA are considered “Consumer Discretionary,” while META and GOOG/GOOGL are considered “Communication Services.” Yet because these names are fundamentally technology platform companies, they have a tendency to trade in sympathy with tech stocks rather than their sector peers.

On a sector basis, as we review the various SPDR sector ETFs, it is perhaps no surprise that Technology stocks led the way in June. Notably, Consumer Discretionary and Communication Services followed, thanks in no small part to the Mag Seven stocks that are heavily represented in those sectors.

There is no question, ever since the end of 2022, exposure to mega cap technology has been favorable. This is a stark contrast with the experience of investors in 2022, when the tech sector crashed. In 2022, the S&P 500 Equal Weighted declined 11.5%, whereas the S&P 500 declined 18.1%.

Keeping this historical perspective in mind is helpful in periods when the mega cap juggernauts of the S&P 500 have momentum. Even with the benefit of the past 18 months of NVIDIA-led outperformance, over the past 20 years, the S&P 500 on a market cap weighted basis has produced similar returns as the equal weighted version. Remarkably, the market cap weighted version of the index has only now caught up to the equal weighted version over a twenty year time frame.

Relevance for Income Builder

Given the yield objective of the Income Builder portfolio, the technology sector, along with other growth sectors, will tend to be under-represented in the portfolio—with certain exceptions, like Texas Instruments (TXN).

In periods of tech/growth outperformance, income-oriented strategies naturally tend to lag. Of course, this means they have the potential to do relatively well when technology and growth perform poorly.

A falling interest rate scenario, in response to weak economic growth, could favor certain Income Builder holdings relative to high multiple technology stocks that may be more sensitive to an economic slowdown.

Most stock market investors tend to have large allocations to funds that mimic or resemble the S&P 500, the Nasdaq and other major indices (for example, through 401k plans and retirement funds). While we view the Income Builder Model Portfolio primarily as a long-term income generation strategy for investors, it also functions as a complement and portfolio diversifier for investors with heavy exposure to technology/growth tilted index funds and ETFs.

Portfolio highlights

Within the Income Builder portfolio in June, we saw strong performance from Mid-America Apartment Communities (MAA), which returned 7%; Digital Realty Trust (DLR), which returned 5%; and Williams (WMB), which returned 4%. The most significant decline came from Carlyle Group (CG), which returned -7%.

Apartment REITs like MAA have gotten attention since Blackstone’s announced buyout of Apartment Income REIT (AIR), which closed on June 28. At a real estate conference held in June, MAA gave positive indications around operating trends. Excess supply within the company’s core sunbelt markets is being absorbed and management is able to push rents.

MAA shares are still some 40% below year-end 2021 peak levels. MAA is differentiated among apartment REITs by its southeastern footprint, with significant exposure to Texas.

MAA would naturally benefit from any acceleration of corporate relocations to Texas and other southern geographies that may be linked to the formation of the Texas Stock Exchange and other initiatives that we have discussed. MAA’s differentiated regional positioning make it an especially attractive long-term play as multi-family real estate appears to be recovering on a national basis.

As AI drives demand for data center capacity, DLR continues to perform well. When we first started writing about DLR, prior to the official launch of 76research, we noted ongoing debates as to whether third party data center operators like DLR would suffer as enterprises migrate to cloud providers.

It is now becoming apparent to all that there is an overall data center capacity shortage, and this is translating into pricing power for DLR. DLR just received an upgrade and substantial price target boost from an influential analyst at JPMorgan on June 28, who cited these factors. Better late than never.

Long-term leases that were struck at lower levels will burn off over the next several years, while spot market rents should continue to grow. As a result, DLR has visibility on significant cash flow and dividend growth in the years to come.

WMB, in a similar way, is benefiting from anticipated data center/AI demand. Investor sentiment towards the natural gas pipeline operator has improved in response to growing acceptance that natural gas will play a vital role in the electrical energy generation required to power AI data centers. Perceptions of a higher likelihood of a Trump victory in November also benefit pipeline operators.

CG shares continued to see some weakness, as we noted last month, after strong performance earlier in the year, in response to a mixed quarterly earnings result. We continue to believe the alternative asset manager is on a solid growth trajectory.    

Key metrics

Valuation detail

Performance detail

Company snapshots

Blackstone (BX)

Crown Castle (CCI)

Digital Realty Trust (DLR)

Diamondback Energy (FANG)

Texas Instruments (TXN)

VICI Properties (VICI)

Williams (WMB)

Carlyle Group (CG)

Kinder Morgan (KMI)

Mid-America Apartment (MAA)

Permian Resources (PR)

Sempra (SRE)

WEC Energy Group (WEC)

The 76research Income Builder Model Portfolio is intended for income-oriented investors and is managed to generate an overall yield that is materially higher than broad equity indices. The portfolio primarily includes stocks with above average dividend yields from a cross section of industries and may also include ETFs that offer exposure to fixed income instruments. While investments are screened for their income and income growth characteristics, specific holdings are chosen based on valuation and general business quality, growth and risk considerations.

Disclaimer

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